"2018 Is Looking Increasingly Like 2015": Why JPMorgan Expects Even More Pain From China

With the yield curve flattening, Emerging Markets sliding, China's currency tumbling almost as fast as its equity markets, and the global economy once again on the skid, comparisons between 2018 and 2015 are becoming increasingly louder. Indeed, with the Chinese renminbi losing 3.5% against the dollar over the past two weeks alone, and a sharp 5.5% since the middle of April when the PBOC first cut its Required Reserve Ratio, indicating a new easing phase has begun, this has been a steeper depreciation in the Yuan than the surprising August 2015 devaluation.

This in turn reinforced expectations that Chinese authorities are more willing to let their currency weaken to prevent the trade-weighted exchange rate, which has been trending upwards over the past year, from rising too much.

Compounding China's paradox, the stealth devaluation comes at a time when Beijing had been forced into a tighter stance earlier in the year with rate hikes in lockstep with the Fed, an accelerating deleveraging process, regulatory tightening and a tacit acceptance of a stronger CNY in order to avoid provocations on the trade front.

Furthermore, as Goldman FX strategists wrote over the weekend , the calculus shifted with the crystallisation of some of the trade war risks, coupled with an acute deceleration in the Chinese economy, leaving Chinese policymakers unable to rely on a positive external trade impulse to offset domestic tightening and have already taken steps to respond to the weaker credit and money data and soft activity prints such as fixed asset investment. As a result, tates moved lower, there has been media chatter suggesting an increase in bank credit quotas, and the PBOC enacted another cut in the reserve requirement ratio last weekend, the second for the year sparking further devaluation concerns.

Meanwhile, as China devalued sharply against the USD, it has also been devaluing against its three broader trade-weighted baskets (launched by the China Foreign Exchange Trade System, or CFETS, in late 2015 in an attempt by the PBOC to discourage investors from exclusively focusing on yuan’s fluctuations against the dollar) if by less. As JPMorgan shows in the chart below, the CFETS indices lost around 2.0% over the past two weeks, lagging the 3.5% depreciation of the yuan against the dollar. But as JPM's Nikolaos Panigirtzoglou contends, "despite the depreciation over the past two weeks, the pressure on Chinese policy makers to let the Chinese renminbi decline further against the dollar remains given how elevated the CFETS trade-weighted indices are still."

And, suggesting more downside is to come for the CNY, "this depreciation pressure would increase if trade tensions with the US escalate and the dollar rises further from here."

* * *

However, it is not only currency depreciation that is the similarity with 2015 when it comes to Chinese financial markets: according to JPM, the big Chinese stock market correction, which recently sent the Shanghai Composite into a bear market, is another similarity.

JPMorgan explains:

The Chinese equity market is down 13% YTD and is one of the worst-performing markets in the world. During 2015, we had another big correction in Chinese equities as they lost 40% in the summer of 2015. Similar to this year, currency depreciation pressures exacerbated the sell-off at the time.

However, as Panigirtzoglou notes, there was an important difference: during 2015, the equity market collapse was largely driven by retail investor deleveraging, and as we discussed at the time, this was represented by the collapse in margin debt balances, a proxy for domestic retail investor flows.

The JPM chart below shows China’s margin transactions, i.e. leverage borrowed to buy or sell shares as percentage of the free float of the Shanghai Stock Exchange: "they had fallen sharply during the second half of 2015 after topping at 18% in July of that year. But they stabilized at around 10% of the free float of the Shanghai Stock Exchange since then and are little changed this year."

To JPM the lack of retail margin liquidation suggests that institutional rather than retail investors are more likely to have been responsible for this year’s rout in Chinese equities. More from Panigirtzoglou:

This is consistent with our position proxy for Chinese equities based on CSI 300 index futures shown in Figure 4. This position proxy is based on cumulative daily absolute changes in open interest multiplied by the sign of the CSI 300 futures price change every day. It points to significant reduction in net long positions by futures investors YTD.

What JPM says is "striking" about the above chart is that if indeed institutions are selling, they have only just begun:

the decline in this position indicator so far this year has been rather small compared to the position buildup of 2016/2017.

In other words, "the open interest in Chinese equity futures is far from signaling capitulation."

Which brings us to JPMorgan's conclusion: if indeed both the Yuan and stocks are set to continue declining on concerns of escalating trade wars, coupled with margin limit positions being hit on institutional stock loans, it is possible that another global risk-off wave could be unleashed with China now set to become the epicenter of the next Emerging Market turmoil:

In all, the combination of Chinese equity market declines and currency depreciation pressures revive memories of 2015, and this combination has the potential to unsettle risky markets. Especially if a hawkish Fed or an escalation of trade tensions put further upward pressure on the dollar.

It is the combination of these market risks emanating from China that "make 2018 look even more like 2015."